YOU DECIDE: What's behind 'cap and trade?'

June 12, 2009

Media representatives:For a black-and-white or color copy of this photo, call 919.513.3127 or e-mail dave_caldwell@ncsu.edu.

As the debate about the government's approach to global warming heats up, there are some new terms being thrown around, and one of them is "cap and trade."

Let me say at the outset that I have no ability to judge whether global warming is or is not occurring, nor do I have the training to evaluate the environmental impacts if it is. What I can do, however, is explain the economics of some of the public policy approaches to the issue of global warming and climate change.

If global warming and climate change are occurring as a result of human behavior, then economists would call these occurrences "economic externalities." An economic externality is a byproduct of some action, where the action is not necessarily intended to produce that byproduct. If the byproduct is harmful, we call it a "negative economic externality." If the byproduct is beneficial, it's termed a "positive economic externality."

Let's say I love azaleas (which I really do), and let's say I plant about 50 azaleas in my backyard. When spring comes and my azaleas bloom, my neighbor can sit on his porch and enjoy the great sight and smell of the plants. I didn't intend this; I planted the azaleas for my enjoyment. But my neighbor receives an unintended benefit, so my action of planting azaleas has created a positive economic externality.

Now let's go in the opposite direction, and say I don't maintain my yard, and not only that, I also park decaying cars and appliances in my yard, resulting in a major eyesore for my neighbors. Now my actions have created a negative economic externality.

There are tons of positive and negative economic externalities, and most of them we simply enjoy (the positive ones) or tolerate (the negative ones). However, for serious externalities, like air pollution, economists have developed some approaches.

One of these is "cap and trade." The cap part means some group of experts would decide how much air pollution (for example, CO2 emissions) is allowable each year. Pollution permits would be sold to businesses that emit CO2. The trade part indicates businesses could buy and sell the pollution permits among themselves. This might happen, for example, if a firm discovers a technology that allows it to significantly reduce its pollution levels.

Advocates of cap and trade say it gives businesses a financial incentive to reduce pollution, and the pollution standards (the allowable levels of pollution) could be gradually eased in over time. Critics say the pollution permits would add to business costs, and these costs would have to be absorbed by lower profits to owners, lower wages to workers, or higher prices to customers.

An alternative approach to cap and trade is a pollution tax, also known as a carbon tax when applied to the pollution associated with global warming. Whereas cap and trade is focused on the business sector, a carbon tax would be applied directly to consumers. Simply put, a tax would be put on any product or activity identified as contributing to global warming.

Supporters of the carbon tax say it would send a strong signal to consumers that their behavior can affect the environment, and that if they use products that contribute to pollution, they will have to pay a price. Supporters also say increasing the cost of pollution will give a big impetus to new technology and new fuels that are non-polluting.

Others warn that a carbon tax, to be effective in reducing pollution, could cost households thousands of dollars annually in new taxes. They argue that most households simply can't afford such taxes, particularly with the current condition of the economy.

There is a way for the consumer cost of the carbon tax and the cap and trade program to be blunted. This is for the tax revenues collected from those methods to be returned to consumers in a way unrelated to how much pollution they create. Economists call this a "price and income" swap. The tax increases the price of polluting products to consumers, but the refund augments their income, thereby making them no worse off. However, this method will cause consumers to shift their buying away from taxed items to other purchases.

What to do about the potential for global warming and climate change may be one of the biggest issues of our time. Public policies like cap and trade and a carbon tax could have big impacts on both our economy and our wallets. Keep your eyes on the details of these proposals, including who pays the costs and what's done with the government revenues, in deciding the best path for the environment and for you.

-30-

Dr. Mike Walden is a William Neal Reynolds Professor and North Carolina Cooperative Extension economist in the Department of Agricultural and Resource Economics of N.C. State University's College of Agriculture and Life Sciences. He teaches and writes on personal finance, economic outlook and public policy. The Department of Communication Services provides his You Decide column every two weeks. Earlier You Decide columns are at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm